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BASEL III – CAPITAL REGLULATIONS

Introduction:

The main objective of the Basel III framework issued by the Basel Committee on BankingSupervision (BCBS) in Dec. 2010 is to improve the banking sector’s ability to absorb shocksarising from financial and economic stress, whatever the source, thus reducing the risk ofspillover from financial sector to real economy. The framework is to strengthen the bank- leveli.e. micro prudential regulation, with the intention to raise the resilience of individual bankinginstitutions in periods of stress. These new global regulatory and supervisory standards mainlyseek to raise the quality and level of capital to ensure banks are better able to absorb losses onboth a going concern and a gone concern basis, increase the risk coverage of the capitalframework, introduce leverage ratio to serve as a backstop to the risk-based capital measure,raise the standards for the supervisory review process and public disclosures etc. The macroprudential aspects of Basel III are largely enshrined in the capital buffers. Both the buffers i.e.the capital conservation buffer and the countercyclical buffer are intended to protect thebanking sector from periods of excess credit growth.

A. Guidelines on Minimum Capital Requirement (Pillar 1)

The Basel III capital regulations continue to be based on three-mutually reinforcing Pillars, viz. minimum capital requirements (Pillar 1), supervisory review of capital adequacy(Pillar 2), and market discipline (Pillar 3) of the Basel II capital adequacy framework. UnderPillar 1, the Basel III framework will continue to offer the three distinct options for computingcapital requirement for credit risk and three other options for computing capital requirement foroperational risk, albeit with certain modifications / enhancements. These options for credit andoperational risks are based on increasing risk sensitivity and allow banks to select an approachthat is most appropriate to the stage of development of bank's operations. The options availablefor computing capital for credit risk are:-

a) Standardised Approach,

b) Foundation Internal Rating Based Approach; and

c) Advanced Internal Rating Based Approach.

The options available for computing capital for operational risk are:-

a) Basic Indicator Approach (BIA),

b) The Standardised Approach (TSA); and

c) Advanced Measurement Approach (AMA).

Keeping in view the Reserve Bank’s goal to have consistency and harmony with international standards, as also capital efficiency likely to accrue to the banks by adoption of theadvanced approaches, a time schedule was laid down in 2009 that all commercial banks inIndia (excluding Local Area Banks and Regional Rural Banks) may switch over to InternalRating Based Approach (Both Foundation as well as Advanced Internal Rating BasedApproach) for credit risk and Advanced Measurement Approach for operational risk by31.03.2014. Accordingly, banks were advised to undertake an internal assessment of their

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preparedness for migration to advanced approaches and take a decision with the approval oftheir Boards/RBI, whether they would like to migrate to any of the advanced approaches. Banksmay choose a suitable date to apply for implementation of advanced approach.

The provisions of Basel III include:-

a) The Basel III capital regulation has been implemented from April 1, 2013 in India inphases.

b) As per the transitional arrangement under the framework, the regulations would be fullyimplemented by implemented as on March 31, 2019.

c) Banks are required to maintain a minimum Pillar 1 Capital to Risk-weighted Assets Ratio(CRAR) of 9% on an on-going basis (other than capital conservation buffer and countercyclical capital buffer etc.).

d) Capital requirements for the implementation of Basel III guidelines are lower in the initial periods and higher in later years.

e) The RBI may consider prescribing a higher level of minimum capital ratio for each bankunder Pillar 2 framework on the basis of their respective risk profiles and their riskmanagement systems.

f) Banks are required to maintain a capital conservation buffer of 2.5%, comprised ofCommon Equity Tier 1 capital, above the regulatory minimum capital requirement of 9%.

g) Banks are required to comply with the capital adequacy ratio at two levels viz.consolidated (Group) and standalone (Solo) level.

Under the Basel II framework, the total regulatory capital comprises of Tier I (core capital)and Tier 2 capital (supplementary capital). Regulatory capital will predominantly consist ofCommon Equity under Basel III. Non-equity Tier 1 and Tier 2 capital would continue to formpart of regulatory capital subject to eligibility criteria as laid down in Basel III.

Composition of Regulatory Capital

The total regulatory capital fund will consist of the sum of the following categories:-

(i) Tier 1 Capital (going-concern capital*): comprises of:-(a) Common Equity Tier 1 capital(b) Additional Tier 1 capital

(ii) Tier 2 Capital (gone-concern capital*)

(*From regulatory capital perspective, going-concern capital is the capital which can absorblosses without triggering bankruptcy of the bank. Gone-concern capital is the capital which willabsorb losses only in a situation of liquidation of the bank).

Banks are required to compute the Basel III capital ratios in the following manner:-

Common Equity Tier 1Capital Ratio

Common Equity Tier 1 Capital

Credit Risk RWA* + Market Risk RWA + Operational RiskRWA

Tier 1 Capital Ratio Eligible Tier 1 Capital

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RWA

Total Capital (CRAR#) Eligible Total Capital Credit Risk RWA + Market Risk RWA + Operational RiskRWA

* RWA = Risk weighted Assets; # Capital to Risk Weighted Asset Ratio

Elements of Capital funds – Indian Banks

(i) Common Equity Tier 1 capital i) Common shares (All common shares should ideally be the voting shares as detailed in

RBI M. Cir.)ii) Stock surplus (share premium)iii) Statutory reservesiv) Capital reserves representing surplus arising out of sale proceeds of assetsv) Other disclosed free reserves, if anyvi) Balance in Profit & Loss Account at the end of previous yearvii) Profit for current year calculated on quarterly basis as per the formula given in RBI Cir.

(Less: Regulatory adjustments/ deductions)

(ii) Additional Tier 1 capitali) Perpetual Non-cumulative Preference shares (PNCPS) ii) Stock surplus (share premium)iii) Debt capital instrumentsiv) Any other type of instruments as notified by RBI from time to time.

(Less: Regulatory adjustments/ deductions)

(iii) Tier 2 Capital

i) General Provisions and Loss Reservesii) Debt capital instruments issued by banksiii) Preference share capital instruments (PCPS/RNCPS/RCPS)iv) Stock surplusesv) Revaluation reserves at a discount of 55%vi) Any other type of instruments generally notified by RBI for inclusion under Tier 2 capital

(Less: Regulatory adjustments/deductions)

Elements of Capital funds – Foreign Banks

Common Equity Tier I capital i) Interest free funds from H.O.ii) Statutory reservesiii) Remittance surplus retained in Indian Books (non-repatriable)iv) Interest free funds remitted from abroad for acquisition of property

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v) Capital reserves arising out of sale of assets (non-repatriable), etc. (Less: Regulatory adjustments/ deductions)

Additional Tier 1 capital i) H.O. borrowings for foreign currency ii) Any other item as allowed by RBI

(Less: Regulatory adjustments/ deductions)Tier 2 Capital

i) General Provisions and Loss Reservesii) H.O. borrowings in foreign currencyiii) Revaluation reserves at a discount of 55%

(Less: Regulatory adjustments/deductions)

Capital requirementa) All scheduled commercial banks (excl. LABs & RRBs) operating in India shall maintain a

Minimum Total Capital (MTC) of 9% of total Risk Weighted Assets (RWA) i.e. capital torisk weighted assets (CRAR) as against 8% prescribed under Basel III rules.

b) Out of the MTC of 9%, Common Equity Tier I (CET1) capital shall be at least 5.5% ofRWA (i.e. for credit risk + market risk + operational risk) on an ongoing basis (Basel III atleast 4.5% of RWA).

c) Tier 1 capital shall be at least 7% of RWA on an ongoing basis. In other words, withinthe Tier 1 capital, Additional Tier 1 capital shall be maximum 1.5% of RWAs (Basel III6%).

d) Total Capital (Tier 1 capital + Tier 2 capital) shall be at least 9% of RWAs on an ongoingbasis i.e. within the minimum CRAR of 9%, Tier 2 capital can be admitted maximum upto 2% (Basel III Tier 1 + Tier 2 shall be 8%).

e) If a bank has complied with Minimum Common Equity Tier 1 and Additional Tier 1 capitalratios, then the excess Additional Tier 1 capital can be admitted for compliance with theminimum CRAR of 9% of RWAs.

f) In addition to the minimum Common Equity Tier 1 capital of 5.5% of RWAs, banks arealso required to maintain a capital conservation buffer (CCB) of 2.5% of RWAs (dealtseparately) in the form of Common Equity Tier 1 capital.

With the full implementation of capital ratios (For smooth migration to these capital ratios,transitional arrangements have been provided) and CCB the capital requirements would be asfollows:-

Regulatory Capital As % toRWAs

1. Minimum Common Equity Tier 1 Ratio 5.502. Capital Conservation Buffer (comprised

of Common Equity)2.50

3. MCE Tier 1 Ratio + CCB 8.004. Additional Tier 1 Capital 1.505. Minimum Tier 1 Capital Ratio (1 + 4) 7.00

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6. Tier 2 Capital 2.007. Minimum Total Capital Ratio (MTC) {5 +

6 }9.00

8. MTC + CCB (7 + 2) 11.50

a) The ‘capital funds’ comprises of the sum total of Common Equity Tier 1 capital,Additional Tier 1 capital, and Tier 2 capital eligible for computing and reporting CRAR ofthe bank. It may be noted that the term ‘Common Equity Tier 1 capital’ does notinclude capital conservation buffer and countercyclical capital buffer.

b) For the purpose of reporting Tier 1 capital and CRAR, any excess Additional Tier 1 (AT1)capital and Tier 2 (T2) capital will be recognized in the same proportion as thatapplicable towards minimum capital requirements. In other words, to admit any excessAT1 and T2 capital, the bank should have excess CET1 over and above 8% (5.5%+2.5%).

c) In cases where the a bank does not have minimum Common Equity Tier 1 + capitalconservation buffer of 2.5% of RWAs as required but, has excess Additional Tier 1 and /or Tier 2 capital, no such excess capital can be reckoned towards computation andreporting of Tier 1 capital and Total Capital.

Regulatory adjustments/deductions

The regulatory adjustments / deductions which will be applied to regulatory capital both at soloand consolidated level are as under:-

a) Goodwill and all other intangible assets are required to be deducted from the CommonEquity component of Tier 1.

b) DTA associated with accumulated losses and DTA (other than associated withaccumulated losses) net of DTL.

c) The amount of cash flow hedge reserve which relates to hedging of items that are notfair valued in the balance sheet (including projected cash flows) should be derecognizedin the calculation of Common Equity Tier 1.

d) Shortfall of stock of provisions to expected losses under the Internal RatingsBased (IRB) approach should be deducted in the calculation of Common Equity Tier 1capital.

e) Other areas such as Gain-on-Sale Related to Securitisation Transactions, definedbenefit pension fund liabilities, Investment in a bank’s own shares, etc. are to bededucted appropriately from Common Equity Tier 1 capital.

f) The investment of banks in the regulatory capital instruments of other financial entitiescontributes to the inter-connectedness amongst the financial institutions and hence itshould be deducted from the respective tiers of regulatory capital so as to avoiddouble counting of capital in the financial system.

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g) Reciprocal cross holdings of capital might result in artificially inflating the capitalposition of banks and hence such holdings of capital has to be fully deducted fromcomponent of capital (Common Equity, Additional Tier 1 and Tier 2 capital) for whichthe capital would qualify if it was issued by the bank itself,.

h) Capital instruments which no longer qualify as non-common equity Tier 1 capital orTier 2 capital (e.g. IPDI and Tier 2 debt instruments with step-ups) are to be phasedout beginning 01.01.2013, etc.

Transitional ArrangementsAs per Basel III terms, in order to ensure smooth migration without any near stress,appropriate transitional arrangements for capital ratios have been made which commencedas on 01.04.2013. Capital ratios and deductions from Common Equity will be fully phased-inand implemented as on 31.03.2019 and accordingly the phase-in arrangements for SCBsoperating in India are drawn as under:-Transitional Arrangements (Excl. LABs and RRBs)

Minimum capital ratios

01.04.13 31.03.14 31.03.15 31.03.16 31.03.17 31.03.18 31.03.19

CET 1 4.50 5.00 5.50 5.500 5.50 5.500 5.50CCB - - - 0.625 1.25 1.875 2.50Minimum CET1 + CCB

4.50 5.00 5.50 6.125 6.75 7.375 8.00

Minimum Tier 1 capital

6.00 6.50 7.00 7.00 7.00 7.00 7.00

Minimum Total capital *

9.00 9.00 9.00 9.00 9.00 9.00 9.00

Minimum Total Capital + CCB

9.00 9.00 9.00 9.625 10.25 10.875 11.50

Phase-in of all deductions from CET 1 (in %) #

20 40 60 80 100 100 100

* The difference between the minimum total capital requirement of 9% and the Tier 1 requirement can be met with Tier 2 and higher forms of capital;# The same transition approach will apply to deductions from Additional Tier 1 and Tier 2 capital

The regulatory adjustments (i.e. deductions and prudential filters) would be fully deducted from Common Equity Tier 1 only by March 31, 2017. During this transition period,the remainder not deducted from Common Equity Tier 1 / Additional Tier 1 / Tier 2 capital willcontinue to be subject to treatments given under Basel II capital adequacy framework.

1. Capital charge for Credit Risk

RBI has identified external credit rating agencies that meet the eligibility criteria specified underthe revised Framework. Banks are required to choose the external rating agencies identified byRBI for assigning risk weights for capital adequacy purposes as per the mapping furnished inthe Basel III guidelines.

Claims on Domestic Sovereigns (standard Assets)

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a. Both fund based and non fund based claims on the Central Government includingCentral Govt. guaranteed claims carry zero risk weight.

b. Direct Loans/credit/overdraft exposure, if any, of banks to State Govt. and investment inState Govt. securities carry zero risk weight. State Government guaranteed claims willattract 20 per cent risk weight’.

c. Risk weight applicable to Central Govt. exposure (Zero risk weight) would also apply toclaims on RBI, CGTMSE, and Credit Risk Guarantee Fund Trust for Low IncomeHousing (CRGFTLIH). The claims on ECGC will attract a risk weight of 20%.

d. ‘Amount Receivable from GOI’ under Agricultural Debt Waiver Scheme 2008 is to betreated as claim on GOI and attract zero risk weight whereas the amount outstanding inthe accounts covered by the Debt Relief Scheme shall be treated as a claim on theborrower and risk weighted as per the extant norms.

Claims on Foreign Sovereigns Claims on Foreign Sovereigns in foreign currency would be as per the rating assigned as detailedin the RBI circular. In case of claims dominated in domestic currency of Foreign Sovereign metout of the resources in the same currency, the zero risk weight would be applicable.Claims on Public Sector Entities (PSE)Claims on domestic PSEs and Primary Dealers (PD) would be risk weighted in the samemanner that of corporate and foreign PSEs as per the rating assigned by foreign rating agenciesas detailed in the Circular.

Other claims Claims on IMF, Bank for International Settlements (BIS), and eligible Multilateral

Development Banks (MDBs) evaluated by the BCBS will be treated similar to claimson scheduled banks at a uniform 20% risk weight. Similarly, claims on the InternationalFinance Facility for Immunization (IFFIm) will also attract a 20% risk weight

Claims on Banks incorporated in India and Foreign Banks’ branches in India, theapplicable risk weight is detailed in the RBI Master Circular dt. 01.07.14

Banks’ investment in capital instruments of other banks such investments would not bededucted, but would attract appropriate risk as detailed in the RBI M. Circular.

Claims on corporate Asset Finance Companies (AFCs) and Non-Banking FinanceCompanies-Infrastructure Finance Companies (NBFC-IFC), shall be risk weighted asper the ratings assigned by the rating agencies registered with the SEBI andaccredited by the RBI (Detailed in the Circular).

The claims on non-resident corporate will be risk weighted as per the ratings assignedby international rating agencies.

Regulatory Retail claims (both fund and non-fund based) which meet the Qualifyingcriteria, viz.

a) Orientation Criterion: Exposure to individual person/s or to a small business (Averageannual turnover less than Rs. 50 crore for last 3 years in case of existing or projectedturnover in case of new units);

b) Product Criterion: Exposure (both fund-based and non fund-based) in form of revolvingcredits and lines of credit (incl. overdrafts), term loans & leases (e.g. instalment loansand leases, student and educational loans) and small business facilities andcommitments

c) Granularity Criterion – Sufficient diversification to reduce the risk portfolio; andd) Low value of individual exposures - The maximum aggregated retail exposure to one

counterpart should not exceed the absolute threshold limit of Rs. 5 crore.

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Would attract risk weight of 75% except NPAs. As part of the supervisory review process, theRBI would also consider whether the credit quality of regulatory retail claims held by individualbanks should warrant a standard risk weight higher than 75%.

The RWA on claims secured by mortgage of residential properties would be as under:-

Category of Loan LTV Ratio (%) Risk Weight (%)(a) Individual Housing Loans(i) Up to Rs. 20 lakh 90 50(ii) Above Rs. 20 lakh and up to Rs. 75 lakh 80 50(iii) Above Rs.75 lakh 75 75b) Commercial Real Estate - ResidentialHousing (CRE-RH)

N/A 75

(c) Commercial Real Estate (CRE) N/A 100

Note: 1. The LTV ratio should not exceed the prescribed ceiling in all fresh cases of sanction. In casethe LTV ratio is currently above the ceiling prescribed for any reasons, efforts shall be made to bring itwithin limits.

2. Banks’ exposures to third dwelling unit onwards to an individual will also be treated as CREexposures.

Restructured housing loans should be risk weighted with an additional risk weight of25% to the risk weights prescribed above.

Loans / exposures to intermediaries for on-lending will not be eligible for inclusion under claims secured by residential property but will be treated as claims on corporate orclaims included in the regulatory retail portfolio as the case may be.

Investments in mortgage backed securities (MBS) backed by exposures will begoverned by the guidelines pertaining to securitisation exposures (as detailed in the RBICir.)

Non-performing Assets (NPAs)

The risk weight in respect of the unsecured portion of NPA (other than a qualifying residentialmortgage loan), net of specific provisions (including partial write-offs), shall be:-

Specific Provisions Risk Weight %Less than 20% of outstanding 150At least 20% of outstanding 100At least 50% of outstanding 50

The risk weight applicable for secured NPA is 100%, net of provisions when provisionsreach 15% of the outstanding amount.

NPA Home Loan claims secured by residential property, the risk weight shall be 100%net of specific provisions. In case the specific provisions are at least 20% but less than50% of the outstanding, the risk weight shall be 75% (net of specific provisions) andspecific provisions are 50% or more the applicable risk weight is 50%.

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Other specified categories

Category Risk Weight(%)

01. Venture capital 150 or higher 02. Consumer credit including

personal loans, credit cardreceivables, but excl.educational loan

125

03. Capital market exposure 12504. Investment in capital

instruments of NBFC 125

05. The exposure to equity instruments issued by NBFCs

250

05. Investment in paid up equity ofnon-financial entities (other thansubsidiaries) where investmentis below 10% of equity ofinvestee entity.

Above 10%

125

1111

06. Staff loans backed fully bysuperannuation benefits and/ormortgage of flat/house

20

07. Other loans and advances tostaff eligible for inclusion underretail portfolio

75

08. All other assets 10009. Off balance sheet items (Market

related and non-market relateditems)

As detailed inthe RBICircular.

10. Securitization Exposure As per Cir.Based onrating byexternal creditagency

11. Commercial real estate (MBSbacked)

-do-

Definitions and general terminology

Counterparty Credit Risk (CCR)

CCR is the risk that the counterparty to a transaction could default before the finalsettlement of the transaction's cash flows.

Securities Financing Transactions (SFTs)

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SFTs are transactions such as repurchase agreements, reverse repurchaseagreements, security lending and borrowing, collateralised borrowing and lending (CBLO)and margin lending transactions, where the value of the transactions depends on marketvaluations and the transactions are often subject to margin agreements.

Hedging Set

Hedging Set is a group of risk positions from the transactions within a single netting set forwhich only their balance is relevant for determining the exposure amount or EAD under theCCR standardised method.

Current Exposure

Current Exposure is the larger of zero, or the market value of a transaction or portfolio oftransactions within a netting set with a counterparty that would be lost upon the default ofthe counterparty, assuming no recovery on the value of those transactions in bankruptcy.Current exposure is often also called Replacement Cost.

Credit Valuation Adjustment

It is an adjustment to the mid-market valuation of the portfolio of trades with counterparty.This adjustment reflects the market value of the credit risk due to any failure to perform oncontractual agreements with counterparty. This adjustment may reflect the market value ofthe credit risk of the counterparty or the market value of the credit risk of both the bank andthe counterparty.

One-Sided Credit Valuation Adjustment

It is a credit valuation adjustment that reflects the market value of the credit risk of thecounterparty to the firm, but does not reflect the market value of the credit risk of the bankto the counterparty.

Default Risk Capital Charge for CCRThe exposure amount for the purpose of computing for default risk capital charge forcounterparty credit risk will be calculated using the Current Exposure Method (CEM) asdetailed in the Circular.

Capitalization of mark-to-market counterparty risk losses (CVA capital charge)

In addition to the default risk capital requirement for counterparty credit risk, banks are also required to compute an additional capital charge to cover the risk of mark-to-market losses on the expected counterparty risk (such losses being known as creditvalue adjustments, CVA) to OTC derivatives. The CVA capital charge will be calculated inthe manner as indicated in the RBI Circular.

Failed Transactions

a. With regard to unsettled securities and foreign exchange transactions, banks areexposed to counterparty credit risk from trade date, irrespective of the booking or theaccounting of the transaction. Banks may develop and implement suitable systems fortracking and monitoring the credit risk exposure arising from unsettled transactions asappropriate for producing management information that facilitates action on a timely

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basis.

b. Banks must closely monitor securities and foreign exchange transactions that havefailed, starting from the day they fail for producing management information thatfacilitates action on a timely basis

c. Failure of transactions settled through a delivery-versus-payment system (DvP),providing simultaneous exchanges of securities for cash, expose banks to a risk of losson the difference between the transaction valued at the agreed settlement price and thetransaction valued at current market price (i.e. positive current exposure).

d. For DvP Transactions - If the payments have not yet taken place five business days after the settlement date, banks are required to calculate a capital charge bymultiplying the positive current exposure of the transaction by the appropriate factor asgiven in the Circular. In order to capture the information, banks may upgrade theirinformation systems in order to track the number of days after the agreed settlementdate and calculate the corresponding capital charge.

e. For non-DvP transactions (free deliveries) after the first contractual payment/ delivery leg, the bank that has made the payment will treat its exposure as a loan if the second leg has not been received by the end of the business day.

External Credit Assessment

RBI has identified various credit agencies whose ratings may be used by banks for thepurposes of risk weighting their claims for capital adequacy purposes under the revisedframework as under:-

(a) Brickwork Ratings India Pvt. Limited (Brickwork); (b) Credit Analysis and Research Limited; (c) CRISIL Limited; (d) ICRA Limited; (e) India Ratings and Research Private Limited (India Ratings); and (f) SME Rating Agency of India Ltd. (SMERA)

International Agencies (where specified)

a. Fitch

b. Moodys; and

c. Standard & Poor’s

Banks are required to use the chosen credit rating agencies and their ratings consistently foreach type of claim, for both risk weighting and risk management purposes. The revisedframework recommends development of a mapping process to assign the ratings issued byeligible credit rating agencies to the risk weights available under the Standardised risk weightingframework. Under the Framework, ratings have been mapped for appropriate risk weightsapplicable as per Standardised approach. The risk weight mapping for Long Term and ShortTerm Ratings are given in the Circular.

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Credit Risk Mitigation Techniques

Banks use a number of techniques to mitigate the credit risks to which they are exposed. Forexample, exposures may be collateralised in whole or in part by cash or securities, depositsfrom the same counterparty, guarantee of a third party, etc. In order for banks to obtain capitalrelief for any use of CRM techniques, certain minimum standards for legal documentation mustbe met. All documentation used in collateralised transactions and guarantees must be bindingon all parties and legally enforceable in all relevant jurisdictions. Banks must have conductedsufficient legal review, which should be well documented, to verify this requirement. Suchverification should have a well-founded legal basis for reaching the conclusion about thebinding nature and enforceability of the documents

Few of such CRM techniques are given below:-

a) Collateralized transactions –

The credit exposure is hedged in whole or part by collaterals by a counterparty (party towhom a bank has an on-or off balance sheet credit exposure) or by a third party onbehalf of the counterparty and banks have specific lien over the collaterals

Under the Framework, banks are allowed to adopt either Simple Approach orComprehensive Approach. The former approach substitutes the risk weighting of thecollateral for the risk weighting of the counterparty for the collateraised portion of theexposure and under the latter approach which allows fuller offset of collaterals againstexposures. Comprehensive approach is being adopted by banks in India.

In the comprehensive approach, when taking collateral, banks will need to calculatetheir adjusted exposure to a counterparty for capital adequacy purposes in order totake account of the effects of that collateral.

Hair Cut

In the comprehensive approach, Banks are required to adjust both the amount of theexposure to the counterparty and the value of any collateral received in support of thatcounterparty to take account of possible future fluctuations in the value of either, occasionedby market movements. These adjustments are referred to as ‘haircuts’. The application ofhaircuts will produce volatility adjusted amounts for both exposure and collateral. Thevolatility adjusted amount for the exposure will be higher than the exposure and the volatilityadjusted amount for the collateral will be lower than the collateral, unless either side of thetransaction is cash. In other words, the ‘haircut’ for the exposure will be a premium factor andthe ‘haircut’ for the collateral will be a discount factor.

It may be noted that the purpose underlying the application of haircut is to capture themarket-related volatility inherent in the value of exposures as well as of the eligible financialcollaterals. Where the volatility-adjusted exposure amount is greater than the volatility-adjusted collateral amount (including any further adjustment for foreign exchange risk), banksshall calculate their risk-weighted assets as the difference between the two multiplied by therisk weight of the counterparty.

Banks have two ways of calculating the haircuts viz. (i) Standard supervisory haircuts; usingparameters set by the Basel Committee, and (ii) Own estimate haircuts, using banks’ owninternal estimates of market price volatility. Banks in India shall use only the standardsupervisory haircuts for both the exposure as well as the collateral. The Standard

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Supervisory Haircuts (assuming daily mark-to-market, daily re-margining and a 10 business-day holding period), expressed as percentages, are given in detail in the RBI Circular.

Eligible Financial Collateral in Comprehensive approach

Cash, Gold, Securities issued by Central & State Governments, KVP, NSC (no lock in period is operational), LIC policies, Debt securities (rated by a chosen rating agency), Debt Securities ( not rated by a chosen Credit Rating Agency in respect of whichbanks should be sufficiently confident about the market liquidity), Units of Mutual Funds, etc. areeligible financial instruments for recognition in the Comprehensive Approach.

Calculation of capital requirementFor a collateralised transaction, the exposure amount after risk mitigation is calculated as follows:

E* = max {0, [E x (1 + He) - C x (1 - Hc - Hfx)]}

Where: E* = the exposure value after risk mitigation E = current value of the exposure for which the collateral qualifies as a risk mitigant He = haircut appropriate to the exposure C = the current value of the collateral received Hc =haircut appropriate to the collateral Hfx = haircut appropriate for currency mismatch between the collateral and exposure

The exposure amount after risk mitigation (i.e., E*) will be multiplied by the risk weight of thecounterparty to obtain the risk-weighted asset amount for the collateralised transaction.(Illustrative examples calculating the effect of Credit Risk Mitigation is furnished in the RBICircular).

b) On Balance Sheet Netting –

On-balance sheet netting is confined to loans/advances and deposits. Under this technique,banks have legally enforceable netting arrangements involving specific lien with proof ofdocumentation. Capital requirement is reckoned on the basis of net credit exposure. Banks maycalculate capital requirements on the basis of net credit exposures subject to some conditions aslisted in the Circular.

c) Guarantees –

Explicit, irrevocable, and unconditional guarantees may be taken as credit protection incalculating capital requirements. Guarantees issued by entities with lower risk weight ascompared to the counterparty will lead to reduced capital charges since the protected portion ofthe counterparty exposure is assigned the risk weight of the guarantor, whereas the uncoveredportion retains the risk weight of the underlying counterparty. Detailed operational requirementsfor guarantees eligible for being treated as a CRM are given in the RBI Circular.

2. Capital charge for Market Risk

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Market Risk relates to risk of losses in on-balance sheet and off-balance sheet positions arisingon account of movement in market prices. The market risk positions subject to capital chargerequirement are risks pertaining to interest rate related instruments in trading books andequities and Foreign Exchange risk (including gold and other precious metals) in both tradingand banking books.

Trading book for the purpose of capital adequacy will include:

a. Securities included under the Held for Trading (HFT) categoryb. Securities included under the Available for Sale (AFS) categoryc. Open gold position limitsd. Open foreign exchange position limitse. Trading positions in derivatives, andf. Derivatives entered into for hedging trading book exposures.

Banks are required to manage the market risks in their books on an ongoing basis and ensurethat the capital requirements for market risks are being maintained on a continuous basis, i.e.at the close of each business day. Banks are also required to maintain strict riskmanagement systems to monitor and control intra-day exposures to market risks.

Capital for market risk would not be relevant for securities which have already matured andremain unpaid. These securities will attract capital only for credit risk. On completion of 90 daysdelinquency, these will be treated on par with NPAs for deciding the appropriate risk weightsfor credit risk.

Measurement of capital charge for Interest Rate Risk

The capital charge for interest rate related instruments would apply to current market value ofthe instruments in bank’s trading book and banks are required to maintain capital for marketrisks on an ongoing basis by mark to market their trading positions on a daily basis.

The minimum capital requirement is measured/ expressed in two ways viz. (i) Specific Riskcharge and (ii) General Market Risk (dealt separately).

In view of possible longer holding period and higher risk thereto in respect of debt securitiesheld under AFS category, banks are required to hold capital charge for market risk equal to orgreater of the Specific Risk Capital charge or Alternative Total Capital Charge.

i) Specific Market RiskThe capital charge for specific risk is designed to protect against an adverse movement in theprice of an individual security owing to factors related to the individual issuer both short (shortposition is not allowed in India except in derivatives) and long positions. The specific riskcharges and Alternative Total Capital Charge for various kinds of exposures are detailed inTabular Form in the RBI Circular.

ii) General Market RiskIt relates to charge towards interest rate risk in the portfolio, where long and short position(which is not allowed in India except in derivatives & Central Govt. securities) in different

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securities or instruments can be offset. The capital requirements for general market risk aredesigned to capture the risk of loss arising from changes in market interest rates.

General Market Risk is the sum of the following four components:-

a) The net short (short position is not allowed in India except in derivatives) or long positionin the whole trading book;

b) a small proportion of the matched positions in each time-band (the “verticaldisallowance”);

c) a larger proportion of the matched positions across different time-bands (the “horizontaldisallowance”), and

d) a net charge for positions in options, where appropriate.

The Basel Committee has suggested two broad methodologies for computation of capitalcharge for market risks viz. Standardised Method and Internal Risk Management modelsmethod of which banks have been advised to adopt Standardised Method as banks havenot yet developed their Internal Risk Management system.

Under the standardised method there are two principal methods of measuring market riskviz. a “maturity” method and a “duration” method. It has been decided to adopt standardised“duration” method as the same is more accurate method to arrive the capital charge.Accordingly, banks are required to measure the general market risk charge by calculating theprice sensitivity (modified duration) of each position separately. The mechanics under themethod - Time band and assumed changes in yield are detailed in the Circular for reference. Measurement for capital charge for Equity Risk

The capital charge for equities would apply on their current market value in bank’s trading book. The Minimum capital requirement, to cover the risk of holding or taking positionsin equities in the trading book is detailed in the Circular. The instruments covered includeequity shares, whether voting or non-voting, convertible securities that behave like equities,for example: units of mutual funds, and commitments to buy or sell equity.

Capital charge for specific risk (akin to credit risk) will be 11.25% or capital charge in accordance with the risk warranted by external rating of the counterparty,whichever is higher and specific risk is computed on banks' gross equity positions (i.e. thesum of all long and all short equity positions - short equity position is, however, not allowedfor banks in India). In addition, the general market risk charge will also be 9% on the grossequity positions. These capital charges will also be applicable to all trading book exposures,which are exempted from capital market exposure ceilings for direct investments. Specific Risk Capital Charge for banks’ investment in Security Receipts will be 13.5%(equivalent to 150 per cent risk weight). Since the Security Receipts are by and large illiquidand not traded in the secondary market, there will be no General Market Risk Capital Chargeon them.

Measurement of capital charge for Foreign Exchange Risk

The bank’s net open position in each currency shall be calculated by summing up:

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a) The net spot position (i.e. all asset items less all liability items, including accrued interest, denominated in the currency in question);

b) The net forward position (i.e. all amounts to be received less all amounts to be paidunder forward foreign exchange transactions, including currency futures and the principalon currency swaps not included in the spot position);

c) Guarantees (and similar instruments) that are certain to be called and are likely to beirrecoverable;

d) Net future income/expenses not yet accrued but already fully hedged (at the discretion of the reporting bank);

e) Depending on particular accounting conventions in different countries, any other itemrepresenting a profit or loss in foreign currencies;

f) The net delta-based equivalent of the total book of foreign currency options. The open positions both Foreign exchange and gold are at present risk-weighted at 100% andthe capital charge for market risks in foreign exchange and gold open position is 9%. Theseopen positions, limits or actual whichever is higher, would continue to attract capital charge at 9%.This capital charge is in addition to the capital charge for credit risk on the on-balance sheet andoff-balance sheet items pertaining to foreign exchange and gold transactions.

Measurement of capital charge for Credit Default Swap (CDS) in the trading book, Capitalcharge for Counterparty Credit Risk, Capital charge for Counterparty Risk for CollaterisedTransactions in CDS, Treatment for Illiquid Positions, Valuation Methodologies, etc. are detailedin the RBI Circular for reference.Aggregation of the capital charge for Market Risks

The capital charges for specific risk and general market risk are to be computed separately andthe same can be aggregated as per the Performa table provided in the Circular. Whilecalculating the eligible capital for market risk, it would be necessary to calculate the minimumcapital requirement for credit and operational risk first to ascertain how much component ofcapital is available to support the market risk and the same can be computed.

3. Capital charge for Operational Risk

Operational risk is termed as the risk of loss resulting from inadequate or failed internalprocesses, people and systems or from external events. This includes legal risk, but excludesstrategic and reputational risk. Legal risk includes, but is not limited to, exposure to fines,penalties, or punitive damages resulting from supervisory actions, as well as privatesettlements.

Measurement MethodologiesThree methods for calculating operational risk capital charges in continuum of increasingsophistication and risk sensitivity are provided under NCAF viz.

i) The Basic Indicator Approach (BIA) ii) The Standardized Approach (TSA), and iii) Advanced Measurement Approach (AMA).

Banks are advised, to begin with, to adopt the Basic Indicator Approach (BIA) and RBIwould review the capital requirement under BIA for general credibility and in case it is found

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any laxity, appropriate Supervisory action under Pillar 2 will be considered. The capitalcharge for operational risk is calculated under BIA is as under:-

KBIA = [ � (GI1…n x Į)]/n

Where:KBIA = the capital charge under the Basic Indicator Approach

GI = annual gross income, where positive, over the previous three years

n = number of the previous three years for which gross income is positive

I = 15% (alpha) which is set by the BCBS, relating the industry wide level of requiredcapital to the industry wide level of the indicator.

(Gross income is defined as “Net interest income” plus “net non-interest income” withadjustments as detailed in the circular).

Banks are advised to compute capital charge for operational risk under the BIA as follows:

a) Average of [Gross Income * alpha] for each of the last three financial years, excludingyears of negative or zero gross income

b) Gross income = Net Profit (+) Provisions & Contingencies (+) Operating Expenses

c) Alpha = 15 per cent

Under BIA, banks are required to hold capital for operational risk equal to the average positiveannual gross income over the previous 3 years. In case the gross income for any year is negativeor zero, the same should be excluded while calculating the average. RBI will initiate necessarysupervisory action under Pillar 2 in case the negative gross income distorts banks Pillar I capitalcharge.

Supervisory Review and Evaluation Process (SREP) – (Pillar 2)

The objective of Supervisory Review Process (SRP) is to:-

a. Ensure that banks have adequate capital to support all the risks in their business; and

b. Encourage them to develop and use better risk management techniques formonitoring and managing their risks.

This in turn would require a well-defined internal assessment process within banks through whichthey assure the RBI that adequate capital is indeed held towards the various risks to which they areexposed. The process of assurance could also involve an active dialogue between the bank and theRBI so that, when warranted, appropriate intervention could be made to reduce the risk exposure ofthe bank or augment / restore its capital. Thus, Internal Capital Adequacy Assessment Process(ICAAP) is an important component of the SRP.

The main aspects to be addressed under SRP/ICAAP would include:-

a) The risks that are not fully captured by the minimum capital ratio prescribed under Pillar 1;

b) The risks that are not at all taken into account by the Pillar 1; and

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c) The factors external to the bank.

The capital adequacy ratio prescribed under Pillar 1 is only the minimum and addresses only thethree risks viz. credit, market and operation risks. Holding of additional capital might be necessaryfor banks to take care of the possible under-estimation of risks under the Pillar 1 and the actual riskexposure of a bank vis-à-vis the quality of its risk management architecture. Some of the risks whichare generally exposed to but not fully captured in the regulatory CRAR include:-

a) Interest rate risk in the banking book;b) Credit concentration risk;c) Liquidity risk;d) Settlement risk; e) Reputational risk;f) Strategic risk;g) Risk of under-estimation of credit risk under the Standardised approach;h) Model risk i.e., the risk of under-estimation of credit risk under the IRB approaches;i) Risk of weakness in the credit-risk mitigants;j) Residual risk of securitisation, etc.

It is, therefore, only appropriate that the banks make their own assessment of their various riskexposures, through a well-defined internal process, and maintain an adequate capital cushion forsuch risks. Banks were advised to develop and put in place, with the approval of their Boards, anICAAP, in addition to a bank’s calculation of regulatory capital requirements under Pillar 1,commensurate with their size, level of complexity, risk profile and scope of operations. TheICAAP was operationalised w.e.f. March 2008 by foreign banks and March 2009 by Indian Banks.

Based on the three mutually reinforcing Pillars i.e. Pillar 1, Pillar 2, and Pillar 3, the BaselCommittee lays down four key principles under the SRP as under:-

a) Banks are required to have a process for assessing their overall capital adequacyin relation to their risk profile and a strategy for maintaining their capital levels.

b) Evaluation of banks’ internal capital adequacy assessments and strategies as wellas their ability to monitor and ensure their compliance with the regulatorycapital ratios by Supervisors.

c) Supervisors should expect banks to operate above the minimum regulatorycapital ratios and should have the ability to require banks to hold capital in excessof the minimum.

d) Supervisors should intervene at an early stage to prevent capital from falling belowthe minimum levels required to support the risk characteristics of a particular bankand should require rapid remedial action if capital is not maintained or restored.

The Principles a & c relates to the supervisory expectations while others i.e. b & d deals withthe role of the supervisors under Pillar 2. This necessitates evolvement of an effective ICAAP forassessing their capital adequacy based on the risk profiles as well as strategies for maintainingtheir capital levels. Pillar 2 also requires the Supervisory authorities to put in place an evaluationprocess known as Supervisory Review and Evaluation Process (SREP) and to initiatesupervisory measures as may be necessary. This would also facilitate RBI to take suitable stepseither to reduce exposure of the bank or augment/restore its capital.

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Based on the principles, responsibilities have been casted on banks and Supervisors underSREP and based on which banks are expected to operate above the minimum regulatorycapital ratios commensurate with their individual risk profiles, etc. Under SREP, the RBI willassess the overall capital adequacy through comprehensive evaluation along with AnnualFinancial Inspection (AFI) based relevant data and ICAAP document being received from banksand available information. ICAAP and SREP are 2 important components of Pillar 2.

Every bank (except LABs & RRBs) should have an ICAAP both at solo and consolidated levelsand the responsibility of designing and implementation of the ICAAP rests with the Board.Before embarking on new activities or introducing new products the senior management shouldidentify and review the related risks arising from these potential new products or activitiesand ensure that the infrastructure and internal controls necessary to manage the related risksare in place.

Banks are required to put in place an effective MIS which should provide the board and seniormanagement a clear and concise manner with timely and relevant information concerning theirinstitutions’ risk profile including risk exposure. MIS should be capable of capturing limitbreaches (concentrations) and same should be promptly reported to senior management, aswell as to ensure that appropriate follow-up actions are taken. Risk management processshould be frequently monitored and tested by independent control areas and internal andexternal auditors.

The ICAAP should form an integral part of the management and decision-making culture of abank. The implementation of ICAAP should be guided by the principle of proportionality andRBI expects degree of sophistication in the ICAAP in regard to risk measurement which shouldcommensurate with the nature, scope, scale and the degree of complexity in the bank’s businessoperations.Internal Capital Adequacy Assessment Process (ICAAP)

ICAAP is a comprehensive paper which would provide:-a) detailed information on the ongoing assessment of bank’s entire spectrum of risks;b) how the bank intends to mitigate those risks; and c) Current and future capital necessary thereof reckoning their mitigating factors.

ICAAP, duly approved by the BOD, is to be submitted to RBI. It should contain all the relevantinformation necessary for the bank and RBI to make an informed judgement as to theappropriate capital level of the bank and its risk management approach.

Contents ICAAP document should normally contain various sections as under:-

a) Executive Summaryb) Background c) Summary of current and projected financial and capital positionsd) Capital adequacye) Key sensitivities and future scenarios f) Aggregation and diversificationg) Testing and adoption of the ICAAPh) Use of ICAAP with the bank.

Executive Summary

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Executive Summary would include:a) Purpose of the reportb) Main findingsc) Summary of financial position of the bank, etc.

Background Background should include the relevant organizational and historical financial data for the bank viz. group structure, operating profit, profit before tax, etc. and conclusions from the trends in the data which may have implications for the bank’s future.

Summary of current and projected financial and capital positionsThis section would explain the present financial position of the bank and expected changes tothe current business profile, the environment in which it expects to operate, its projectedbusiness plans (by appropriate lines of business), projected financial position, and futureplanned sources of capital, etc.

Capital adequacyThis would provide description of the bank’s risk appetite, in quantitative terms, amount ofcapital required to meet minimum regulatory needs or whether it suffice to meet its businessplans, etc. The information provided should include the effective date of the ICAAP calculationstogether with the rationale for capital requirement has been assessed, etc.

The section would also discuss the major risks faced by the bank in each categories, viz. creditrisk, market risk, operational risk, liquidity risk, concentration risk, interest rate risk in thebanking book, residual risk of securitization, strategic risk, business risk, reputation risk,pension obligation risk, other residual risk; and any other risks that might have been identified.

The section would further contain the methodology and assumptions on how assessments for each of the major risks have been arrived and the main assumptions made, etc.

Risk oversight and specific aspects of risk management This section discusses the risk management system in the bank, Off-balance sheet exposureswith a focus on securitization, Assessment of reputational risk and implicit support, Assessmentof valuation and liquidity risk, Stress Testing practices, & Sound compensation practices, etc.

Key sensitivities and future scenariosThe section would include how an economic downturn would affect the bank’s capital funds and future earnings and the banks CRAR taking into account the future changes in the projected balance sheet, etc.

The section would further explain on the management actions assumed in deriving the ICAAP inparticular the quantitative impact of management actions and the evidence of managementactions implemented in the past during similar periods of economic stress, etc.

Aggregation and DiversificationThis section would describe how the results of the various separate risk assessments arebrought together and an overall view taken on capital adequacy taking into account the variousrelated factors.

Testing and Adoption of the ICAAPThis section describes the extent of testing that the ICAAP has been subjected to and would

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include the testing and control process applied, models and calculations, test results, etc.

Use of ICAAP with the bankThis section would explain the concept of capital management implemented in the bank. Thiswould further include the extent and use of capital modeling or scenario analysis and stresstesting within the bank’s capital management policy, etc.

Structural Aspects of ICAAP While designing the ICAAP, banks are required comply with certain broad parameters such as:-

a) Every bank must have an ICAAP b) The ICAAP should encompass firm-wide risk profile including risk management

principlesc) Board and Senior Management Oversightd) Policies, procedures, limits and controlse) Identifying, measuring, monitoring and reporting of riskf) Internal controls; and g) Submission of the outcome of the ICAAP to the BOD and RBI. ICAAP should reach the

RBI latest by end of the first quarter (i.e. April-June) of the relevant financial year.

Other features/requirementsa) Review of ICAAP by BOD should be carried annually to assess the success of

implementation and achievement of objectives as envisaged thereunder.b) ICAAP should be an Integral part of the Management and Decision-making Culturec) The implementation of ICAAP should be guided by the principle of proportionalityd) ICAAP should be subject to regular and independent review through an internal or

external audit process, separately from the SREP conducted by the RBI e) ICAAP should be forward looking in nature and banks should have an explicit Board

approved capital plan to achieve its objectives, etc. The adequacy of a bank’s capital is afunction of its risk profile.

f) Being part of ICAAP, the management of the bank should carry out stress tests toevaluate the vulnerability of the bank to some unlikely events or market movements /conditions which could have an adverse impact of the bank

g) Banks to develop suitable methodologies for estimating and maintaining economiccapital.

Operational aspects of ICAAPa) The first and foremost objective of ICAAP is to identify, measure, and quantify the

various material risks associated with the bank.b) The risks to which banks are exposed include credit risk, market risk, operational risk,

interest rate risk in the banking book, credit concentration risk and liquidity risk. c) Banks should not solely rely on the external credit ratings instead conduct analysis of

underlying risks while investing in the structured products as permitted by RBI.d) Bank’s risk management process including the ICAAP should be consistent with the

existing RBI guidelines on these risks.e) If banks adopt risk mitigation techniques, they should understand the risk to be

mitigated and reckoning its enforceability and effectiveness on the risk profile of thebank.

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f) Sound Stress Testing Practices: Stress testing that alerts bank management toadverse unexpected outcomes related to a broad variety of risks and provides anindication to banks of how much capital might be needed to absorb losses shouldlarge shocks occur. It is an important tool that is used by banks as part of theirinternal risk management. Moreover, stress testing supplements other riskmanagement approaches and measures.

g) Sound Compensation Practices: Risk management must be embedded in the culture ofa bank and should be under the critical focus of the Senior Management of the bank.For developing and maintaining a broad and deep risk management culture over time,compensation policies may be drawn which should be linked to longer-term capitalpreservation and the financial strength of the firm, and should consider risk-adjustedperformance measures.

h) Banks should provide adequate disclosure regarding its compensation policies tostakeholders.

Market Discipline - (Pillar – 3)

Market Discipline is termed as development of a set of disclosure requirements so thatthe market participants would be able to access key pieces of information on the scopeof application, capital, risk exposures, risk assessment processes, and in turn the capitaladequacy of the institution. Market discipline can contribute to a safe and sound bankingenvironment. Hence, non-compliance of the prescribed disclosure requirement attracts penaltyincluding financial penalty. Banks should have a formal disclosure policy approved by theBoard of Directors that addresses the bank’s approach for determining whatdisclosures it will make and the internal controls over the disclosure process.

The Pillar 3 disclosures as introduced under Basel III would become effective from01.07.2013 and the first set of disclosures as required should be made by banks as on30.09.2013 (with exception of Post March 31, 2017 template (dealt separately).Banks are required to make Pillar 3 disclosures at least on a half yearly basis,irrespective of whether financial statements are audited, with the exception i.e. CapitalAdequacy, Credit Risk: General Disclosure for all banks; and Credit Risk: Disclosuresfor Portfolios subject to the Standardised Approach. These are to be made at least on aquarterly basis by banks. All disclosures must either be included in a bank’s publishedfinancial results/ statements or at a minimum, must be disclosed on bank’s website.

Banks are required to make disclosures in the prescribed format by RBI. Banks are alsorequired to maintain a ‘Regulatory Disclosures Section’ on their website where all informationrelating to disclosures will be made available to the market participants. The link should beprominently provided on the home page of the website so as to make it easily accessible. Anarchive for at least three years of all templates relating to prior reporting periods should bemade available by banks on their websites.

Post March 31, 2017 Disclosure Template

A common template which will be used by banks to report the details of their regulatorycapital after March 31, 2017 i.e. after the transition period for the phasing-in of deductions isover. It is designed to meet the Basel III requirement to disclose all regulatory adjustments.The template enhances consistency and comparability in the disclosure of the elements ofcapital between banks and across jurisdictions.

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Template during the Transitional Period

During the transition period of phasing-in of regulatory adjustments under Basel III in Indiai.e. from April 1, 2013 to March 31, 2017, banks will use a modified version of the post March31, 2017 template. This template is designed to meet the Basel III requirement for banks todisclose the components of capital which will benefit from the transitional arrangements.

Main Features Template

A common template has been designed to capture the main features of all regulatory capitalinstruments issued by a bank at one place. This disclosure requirement is intended to meetthe Basel III requirement to provide a description of the main features of capital instruments.

Other Disclosure Requirements

This disclosure enables banks in meeting the Basel III requirement to provide the full termsand conditions of capital instruments on their websites.

Banks operating in India are required to make additional disclosures in respect of:-

a. Securitisation exposures in the trading book; b. Sponsorship of off-balance sheet vehicles; c. Valuation with regard to securitisation exposures; and d. Pipeline and warehousing risks with regard to securitisation exposures

Capital Conservation Buffer Framework

ObjectiveThe capital conservation buffer (CCB) is designed to ensure that banks build up capital buffersduring normal times (i.e. outside periods of stress). CCB can be used against losses incurredduring a stressed period. The requirement is based on simple capital conservation rulesdesigned to avoid breaches of minimum capital requirements. Outside the period of stress,banks should hold buffers of capital above the regulatory minimum. When buffers havebeen set off, one way banks should look to rebuild them is through reducing discretionarydistributions of earnings. This could include reducing dividend payments, share buybacks andstaff bonus payments. Banks may also choose to raise new capital from the market as analternative to conserving internally generated capital

The capital conservation buffer can be used only when a bank faces a systemic stress. A bankshould not choose in normal times to operate in the buffer range simply to compete with otherbanks and win market share. This aspect would be specifically looked into by RBI during theSREP. The banks which draw down their capital conservation buffer during a stressed periodshould also have a definite plan to replenish the buffer as part of its ICAAP and strive to bringthe buffer to the desired level within a time limit agreed to with RBI during the SREP.

The framework of capital conservation buffer will enable the banks to:-

a) Strengthen the ability of banks to withstand adverse economic environment conditions,

b) Help increase banking sector resilience both going into a downturn; and

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c) Provide the mechanism for rebuilding capital during the early stages of economicrecovery.

By retaining a greater proportion of earnings during a downturn, banks will be able to helpensure that capital remains available to support the ongoing business operations / lendingactivities during the period of stress. Therefore, this framework is expected to help reduce pro-cyclicality.

FrameworkBanks are required to maintain a capital conservation buffer of 2.5% of RWA in the form ofCommon Equity Tier 1 capital above the regulatory minimum capital requirement of 9%. CCB isto be phased-in over a period of 4 years in a uniform manner of 0.625% per year, commencingfrom 31.3.15. Banks should not distribute capital (i.e. pay dividends or bonuses in any form) incase capital level falls within this range. The constraints imposed are related to the distributionsonly and are not related to the operations of banks. The distribution constraints imposed onbanks, when their capital levels fall into the range, increase as the banks’ capital levelsapproach the minimum requirements. The minimum capital conservation ratios a bank mustmeet at various levels of the Common Equity Tier 1 capital ratios is shown as under:-

Minimum capital conservation standards for individual bankCET 1 Ratio after including the current periods of retained earnings

Minimum Capital Conservation Ratios (in % of earnings)

5.5% - 6.125% 100%>6.125% - 6.75% 80%>6.75% - 7.375% 60%>7.375% - 8.0% 40% >8.0% 0%

It may be observed from the above that a bank with a Common Equity Tier 1 capital ratio in therange of 6.125% to 6.75% is required to conserve 80% of its earnings in the subsequentfinancial year (i.e. payout not more than 20% in terms of dividends, share buybacks anddiscretionary bonus payments is allowed). Basel III minimum capital conservation standardsapply with reference to the applicable minimum CET1 capital and applicable CCB.

During the transition period, the build-up of CCB as prescribed by RBI would be as under:-

Minimum capital conservation standards for individual bankCommon Equity Tier 1 Ratio after including the current periods Minimum Capital

retained earnings Conservation Ratios

As on As on As on (expressed as % of

March 31, 2016 March 31, 2017 March 31, 2018earnings)

5.5% - 5.65625% 5.5% - 5.8125% 5.5% - 5.96875% 100%

>5.65625% - 5.8125% >5.8125% - 6.125% >5.96875% - 80%6.4375%

>5.8125% - 5.96875% >6.125% - 6.4375% >6.4375% - 60%6.90625%

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>5.96875% - 6.125% >6.4375% - 6.75% >6.90625% - 7.375% 40%

>6.125% >6.75% >7.375% 0%

Capital conservation buffer is applicable both at the solo level (global position) as well as at theconsolidated level, i.e. restrictions would be imposed on distributions at the level of both the solobank and the consolidated group.

Leverage Ratio Framework

The leverage ratio provisions in the Basel III document are intended to serve as the basis fortesting the leverage ratio during the parallel run period. The Basel Committee will test aminimum Tier 1 leverage ratio of 3% during the parallel run period from January 1, 2013 toJanuary 1, 2017. The leverage ratio is calibrated to act as a credible supplementary measure tothe risk based capital requirements. The main objective of the leverage ratio framework is:-

a) constrain the build-up of leverage in the banking sector, helping avoid destabilisingdeleveraging processes which can damage the broader financial system and theeconomy; and

b) reinforce the risk based requirements with a simple, non-risk based “backstop”measure

During the period of parallel run, banks should strive to maintain their existing level of leverage ratio but, in no case the leverage ratio should fall below 4.5%. A bank whose leverage ratio is below 4.5% may endeavor to bring it above 4.5% as early as possible. Final leverage ratio requirement would be prescribed by RBI after the parallel run taking into account the prescriptions given by the Basel Committee.

The leverage ratio shall be maintained on a quarterly basis. The basis of calculation at the end of each quarter is “the average of the month end leverage ratio over thequarter based on the definitions of capital (i.e. the capital measure) and the total exposure (i.e.the exposure measure) respectively as detailed in the RBI Circular.

(The criteria for Classification as Common Shares (Paid up Equity Capital) for RegulatoryPurposes for Indian Banks as well as Foreign Banks, Detailed guidelines on issuance ofvarious Debt Instruments viz. Innovative Perpetual Debt Instrument (IPDI), Perpetual Non-cumulative Preference Shares (PNCPS), Debt Capital Instruments, Perpetual CumulativePreference Shares (PCPS), Credit Default Swaps (CDS), Illustrations on Credit RiskMitigation (Loan Exposures) – Calculation of Exposure Amount for Collateralized transactions,Illustrations on computation of capital charge for Counterparty Credit Risk (CCR) – RepoTransactions, Measurement of capital charge for Market Risks in respect of Interest RateDerivatives and Options, An Illustrative Approach for Measurement of Interest Rate Risk inthe Banking Book (IRRBB) under Pillar 2, Redeemable Non-cumulative Preference Shares(RNPS), Redeemable Cumulative Preference Shares (RCPS), Subordinated Debts,Guidelines on Securitization of Standard Assets, Illustrative Approach on Measurement ofCapital Charge for Market Risks in respect of Interest Rate Risk and Derivatives, etc. aregiven in detail in the RBI Master Circular which also may be referred).

(Source: RBI M. Circular dt. 01.07.14)

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